by Kenneth Medford
I’d like to play a game. The following three questions, established by the Swiss Journal of Economics and Statistics, act as a gauge of financial literacy. Give ‘em a shot.
1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much would you have in the account if you left the money to grow?
- More than $102, or Exactly $102, or Less than $102
2. Imagine that the interest rate on your savings account was 1 percent per year and the inflation was 2 percent per year. After one year how much would you be able to buy with the money in the account?
- More than today, or Exactly the same, or Less than today
3. Is this statement true or false? “Buying a single company’s stock usually provides a safer return than a stock mutual fund.”
- True or False
Now, if you had legitimately no clue on any of these, ask yourself “why?” Is it because, as CNBC documented, America has “consistently performed in the middle of the pack” on the PISA (Program for International Student Assessment). Or is it because you’re a part of the “Two-thirds of American adults that can’t pass a basic financial literacy test” according to Forbes? We don’t talk about money growing up. We don’t talk about money in school. We definitely don’t talk about money in “polite society”.
But is another reason we don’t talk about money the fact that we’re not confident about how much we know?
We fear what we don’t understand, but scared money don’t make money. We all need to face that fear and understand some foundations of how money works.
1. Interest
You would have more than $102 after that 5 years, but do you know why? Thanks to Calculatorsoup.com, here’s the breakdown:
A = P(1 + rt)
Where:
- A = Total Accrued Amount (principal + interest)
- P = Principal Amount (The amount of money you start with)
- I = Interest Amount
- r = Rate of Interest per year in decimal; r = R÷100
- R = Rate of Interest per year as a percent; R = r ×100
- t = Time Period involved in months or years
For the example shown, it shakes out like: $110 = $100(1 + .02×5)
When you get a credit card, a mortgage, student loans, et al, you need to understand how interest works because THAT’S how most people end up buried in debt. It’s not just the principle you need to worry about, but the interest that builds on top of it the longer it takes for you to pay it off.
2. Inflation
You would be able to buy less than today, but again, do you know why? Unfortunately, not many people are taught what inflation is. Think of a conversation with an older relative or watching a movie or TV with an older character. You can bet at some point you’ll hear a “back in my day” story of how a movie was a quarter, candy was a penny, and you could go shopping for two weeks with twenty bucks. And yeah, that’s painfully laughable, but that’s because everything increases in cost over time (except technology, but that science wizardry plays by its own rules).
Now imagine, the cost of food, housing, a car, etc are all increasing little by little over time while your income stays the same. Your dollar will become weaker, you’ll be able to buy less, and most people won’t even realize it until they’re in too deep. This is why cost of living adjustments are a necessity.
If the term “cost of living adjustment” is new to you, this is not a raise. This is how a company SHOULD slightly increase the wages of ALL its employees to keep their dollar just as strong as the day they were hired. In a perfect world, we would see that coupled with an increase to minimum wage that would also help offset the Thanos like inevitability of inflation, but that’s a totally different movie.
3. Investments
Investing is the financial version of “don’t put all your eggs in one basket”. Having a diverse portfolio or a mutual fund is better than purchasing a single stock. This one is just another basic rule that most people just never get to hear and it’s also something that is really easy to grasp. If one investment doesn’t pan out, you should always have others than can pick up the slack.
Hype is a trap far too many people fall into based on media. You see movies or TV shows where characters talk about that one, miracle stock/company made them a millionaire, but that’s not how this typically works. While it’s true that if your parents invested in Google back in ‘99, you’d have a pretty insane trust fund by now, that’s more of an exception than the rule. Also, you can’t just throw $10 at something and expect to become a billionaire.
It takes substantial investments, usually in the thousands or tens of thousands of dollars, to see the type of dividends that most people dream of. Basically, unless you happen to have a large amount of disposable income and happen to know who’s making “the next big thing”, it makes far more sense to invest a little in various places. I mean, if Warren Buffet has a diverse portfolio, who are we to disagree with that strategy?
Knowledge Is Power
As humans, we fear the unknown. It is instinctual and is a survival tool that keeps us from mistakenly putting ourselves in harm. When it comes to your money, however, you literally cannot afford to be ignorant. In order to dispel that fear, you simply have to learn how our economy and money in general work. Take this article as a starting point and grow from here. These three I’s, much like Kurt Angle’s, have been the foundation for understanding finances since your grandparents played jacks down by the soda fountain. We all need to know the rules of the game to play. Let’s get to it and get this bag. You know what they say, scared money don’t make money.
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Writer, rhymer, gamer: the easiest way to define the man known as Kenneth Medford. I’m a simple man who loves to learn and loves to help and I wander the digital world trying to find ways to sate my hunger for both. Basically, I’m Galactus but helpful.
Check out my other work here or reach out to me on LinkedIn.